party with only an unsecured claim for breach of the agreement.
However, a debtor cannot reject an interest in real property. If
a farmout agreement constitutes an interest in real property, it
cannot be rejected.

Whether certain oil and gas agreements, including farmout
agreements, may be rejected in bankruptcy is hotly contested.
If a farmout agreement is personal property rather than real
property, the Bankruptcy Code also allows a debtor to sell its
property free and clear of claims and interests that are in bona
fide dispute, thereby effectively clearing title to an asset through
the bankruptcy process.

FARMOUT LESSONS FROM THE VNR BANKRUPTCY

There was no judicial resolution of the legal issue—whether a
farmout is an interest in real property—in the VNR Bankruptcy.
The legal question arises because in Texas, the mineral estate
consists of, among other rights, the right to develop (the drilling
right) the land under lease and this interest is an interest in real
property that cannot be rejected in bankruptcy. It has been
argued that a farmout agreement transfers the drilling right to
the farmee.

Because, however, there are no Texas court opinions which
address whether an interest under a farmout agreement constitutes a real property right, treatment in bankruptcy is unclear.
Although Encana’s treatment relative to its farmout agreement
was ultimately settled without a judicial decree, lessons from
the VNR Bankruptcy can and should be learned by future litigants facing these issues.

IS A FARMOUT AGREEMENT AN INTEREST EXCLUDED
FROM THE BANKRUPTCY ESTATE?

The Bankruptcy Code excludes from property of the estate a
debtor’s interest in liquid or gaseous hydrocarbons that it has
transferred or agreed to transfer pursuant to a farmout agreement. Little legal guidance exists on how this carve-out is applied. There is some consensus that drilled and earned but
unassigned acreage under a farmout agreement is excluded
from the bankruptcy estate, but there is disagreement on whether the carve-out applies to unearned acreage.

Encana asserted that its right to drill and earn wells onundeveloped land subject to the farmout agreement fell squarelywithin the carve-out, was outside of Vanguard’s bankruptcyestate, and thus could not be rejected by Vanguard. Encanaalso argued that not only did the Bankruptcy Code provide aclear provision preventing rejection but that the farmout agree-ment transferred Encana a distinct real property interest, theright to enter and drill under the land subject to the farmoutagreement.Conversely, Vanguard argued that it never “transferred oragreed to transfer” the right to drill the undeveloped acreageto Encana and the farmout agreement lacked sufficient grantinglanguage. Vanguard contended that it maintained the exclusiveright to drill the undeveloped acreage, so Encana could haveno reasonable expectation to do the same. Additionally, Van-guard argued that construing the carve-out to apply to unde-veloped acreage would result in a windfall for the farmee andan unconstitutional taking from the farmor.Because of the settlement, the court never had the opportu-nity to rule on the carve-out’s scope.

CAN A DEBTOR-FARMOR SELL ITS LEASEHOLD FREE
AND CLEAR OF A FARMOUT AGREEMENT?

Outside of bankruptcy, a farmor who wants to sell its leasehold
interest would typically do so subject to an existing farmout
agreement. But what happens in bankruptcy? Vanguard sought
to sell its leasehold free and clear of the farmout agreement.
Encana raised three central arguments against the sale of the
acreage subject to the farmout agreement.

• First, because Encana held a standalone real property interest
in the leasehold (the drilling right), Vanguard could not sell
assets free and clear of Encana’s interest.

• Second, Encana argued to the extent that Vanguard and
Encana shared an undivided interest in the drilling right,
Vanguard could not sell Encana’s co-owned interest outside
of an adversary proceeding.

• Third, Encana argued that because it claimed a real property
interest in Vanguard’s undeveloped leasehold, and because
Texas law recognizes property as unique, Encana could not
be forced to accept monetary satisfaction for its interest and
thus, could not be adequately protected in the sale
proceeds.

Vanguard countered that Encana did not have a real property
interest that could prevent the sale because (i) the farmout
agreement contained nothing more than a right to propose
wells, since Vanguard retained the exclusive drilling right, (ii)
the farmout agreement could not have conveyed a real property
interest to Encana because it did not express a present intent
to convey such interest or contain an adequate description of
the property to be conveyed, and (iii) even if Encana had some
ownership interest in the drilling right and/or the underlying
leasehold, Vanguard could still sell free and clear of Encana’s
interest because it was in dispute. The court ultimately agreed
that there was a bona fide dispute and whether Vanguard and
Encana were co-owners did not prevent a sale. The court did
not rule that Encana didn’t own a real property interest, the
court just held that it was in dispute, and ordered the sale because, according to the court, there is nothing unique about
what amounts to a purely commercial asset that could not be

Farmees often invest millions of dollars to develop
farmout acreage and can assign great value to
undeveloped land that they intend to drill over the
term of the agreement. However, when a farmor
files for bankruptcy, the farmee can suddenly
find itself in an unforgiving landscape where the
treatment of its farmout agreement is far from
certain.